Wednesday, December 17, 2014

November Inflation, Housing, and Mortgages

Recent trends continue. Core minus shelter (C-S) inflation turned negative again, so now we have deflation in 3 out of the 5 recent months, and basically no C-S inflation over the past 5 months, cumulatively. If mortgage credit markets can expand as a result of recent regulatory adjustments, then I expect a domino effect of rising home prices, rising new home production, declining rent inflation, and recovery in Core minus Shelter inflation to follow.

If mortgage credit markets remain stagnant, then I expect this pattern to continue, and the question will be whether wage stickiness has diminished enough and real natural interest rates have risen enough to stop hampering economic growth.

This is a complicated outcome. There will be shelter inflation, but much of that is simply an accounting transfer within households. Households will see rising nominal incomes, but those incomes won't rise as much in real terms because they will be spending much of the extra income on rent...to themselves. Since this is a transfer of income which doesn't involve any actual change in cash flows for home-owning households, it won't be a relevant issue regarding those households' economic decisions. (Except, since this issue arises from a stymied housing market, household estimates of their net worth will be somewhat lowered by the low real estate prices.)

So real incomes will be rising faster than they appear among home-owning households, but households that rent will see stagnating real incomes, as their nominal income gains will accrue to landlords. This is already happening, and we can see the market responses, one of which is a very strong multi-unit residential construction market, relative to single family homes. In this scenario, if RGDP is our jumping off point for measuring economic growth, then households and landlords will have additional real discretionary income equal to about 1% of RGDP, compared to the official measure. (This is because their imputed rent will rise due to rent inflation, which will be subtracted from nominal GDP growth.) Since this is, at its core, a product of lower real estate equity, it is essentially the same economic effect that we would see if homes rose in value and households pulled 1% of GDP out of growing home equity value and used it for household consumption. Except, in that case, the extra spending would be measured as NGDP growth. If the rising home prices were a product of wider access to real estate credit, then it would also be associated with rising RGDP, since new home building would ease rent inflation.

So, while I see this Core minus Shelter inflation as a bad sign, it is mostly as a sign of potentially catastrophic deflation. The odds of Fed policy becoming far too tight surely are higher in a context where most core spending is already deflationary.

But, if real wage growth rises, as it should with low unemployment rates, and if natural interest rates are above zero, as they should be in a mature recovery with low unemployment and solid NGDP growth, and if households, in effect, automatically are capturing and spending their real estate capital gains, inflation might not be as important as it is when NGDP, employment, and interest rates are plummeting.

I will look at some housing issues a bit more in the next post.

PS: Commenter TravisV sees inflation as more important in the near term, and while my review of the topic has led to several posts nibbling around the edges of this topic, I still need to put together a post looking at near term Fed policy scenarios more directly.

I agree, probably not. My hope is that (1) the American economy can expand enough on its own momentum that excess reserves will start flowing into new credit at a high enough rate to induce some inflation and/or (2) the new loosening of mortgage regulations will induce enough new home building to (a) further improve the labor market, (b) create supply-side disinflation from relatively lower rents, and (c) expand bank balance sheets.

But, lacking either of these, I agree that we would be likely to find ourselves stuck at the zero lower bound with a central bank unwilling to move us to higher NGDP. It might even be worse here than in Japan, because (I think Sumner has written about this) Japan doesn't have as strong of a sticky-wage norm as the US, so I suspect that the US would be more likely to see higher unemployment in that case.